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By Philip D. Morrison, Esq.
Deloitte Tax LLP, Washington, DC
As I have written in prior commentaries, the Subpart F foreign base company sales income rules under §954(d)(2) dealing with branches comprise one of those sets of rules that, no matter how often you deal with them, you'd better re-read them before expressing a view on any new factual situation. This is in part due to the complexity of the language used and in part due to the complexity of the rules the language is intended to express. The relatively recent "substantial contribution" manufacturing regulations addressed some of the thorny questions that arise when dealing with the manufacturing branch rules, but some basic, as well as some not-so-basic, questions remain with respect to purchase or sales branches.
One of the oddest I have come across is whether a U.S.purchase or sales branch of a controlled foreign corporation (CFC) can create Subpart F foreign base company sales income so as to cause an inclusion for the CFC's U.S. shareholders. CFCs do not, typically, have U.S. branches. In today's more-integrated economy, however, it is not uncommon for regional or even global management activities regarding purchasing, marketing, or selling to rise to the level of a branch.
Where North American regional management is located in the United States, as is typical for a U.S. multinational, a Canadian or Mexican distributor CFC could have a U.S. purchase or sales branch. In some cases, the CFC distributor could buy goods directly from a sister CFC sourcing company in the Far East with the significant involvement of U.S. personnel. In others, the CFC distributor's marketing and sales efforts could be directed by the U.S. parent or aided by significant input (including customer contact) from the U.S. parent or an affiliate or by the CFC distributor employees working regularly with U.S. parent employees in the United States. In either case, those U.S. activities could be conducted directly by dual CFC/U.S. parent employees or by the U.S. parent or a U.S. affiliate (through their employees) acting as agent(s) for the CFC. In each of these cases, there is a possibility that the distributor CFC might have a U.S. purchase or sales branch that would cause the CFC and the U.S. branch to be treated as separate corporations and the CFC to lose a significant portion of its "same country" exception from the Subpart F foreign base company sales income rules.
Even more troubling is the case where, for example, a low-tax Far East purchasing or "sourcing" company might have a U.S. branch because global management engages in purchase and/or sales activities on its behalf that might rise to the level of a purchase or sales branch. While, in theory, this should be fairly easy to avoid, in practice, it may make business sense for there to be tight integration of activities performed by employees of U.S. affiliates on behalf of the sourcing company and employees of the sourcing company or even to have sourcing company employees working in the United States.
The first line of defense, or course, is to rely on the Ashland1 and Vetco2 cases. Those cases hold, generally, that a separate corporation cannot be a branch of another corporation. Still, where CFC employees or dual employees work in the United States on behalf of the CFC, rather than where the CFC explicitly hires a U.S. affiliate, those cases may not provide protection.
So what if there's a U.S. purchase or sales branch, most readers will ask, won't the U.S. branch be high-taxed and, therefore, not give rise to the tax rate disparity that causes the branch rule to apply? Unfortunately, no. The U.S. branch in the situations posed above typically will be subject to zero U.S. tax; and zero will often (almost always?) be less than 90% of, and at least five percentage points less than, the effective rate of tax on the CFC under the hypothetical set of assumptions imposed by the tax rate disparity test. This U.S. branch tax exemption is the result of the liberality the Code shows towards certain income of foreign corporations in the United States. While sales income otherwise reported by the CFC might be attributed to the U.S. branch of the CFC due to its purchasing or selling activity, it is highly likely that a foreign office of the CFC will materially participate in the sale and that the goods sold will be destined for use, disposition, or consumption outside the United States. In such a case, §865(e)(2)(B) will permit the sales to be foreign-sourced (assuming title passage offshore). As foreign-source sales income, then, §864(c)(4)(B)(iii) will exempt such income from treatment as effectively connected income (ECI).
Once there is a branch with a tax rate disparity from the "remainder" of the CFC, one must treat the branch and remainder as separate corporations. As a technical matter, that may appear to solve the potential problem. Under Regs. §1.954-3T(b)(2)(ii)(a), the branch will be treated as a wholly owned subsidiary of the CFC that is incorporated in the country in which the branch is located. Because the branch operations are in the United States, this rule appears to create a hypothetical, separate, U.S. corporation as a subsidiary of the purchase or sales CFC. Income of a U.S. corporation does not appear, as a technical matter, ever to constitute Subpart F income within the meaning of §952. Section 952(a) declares that the term Subpart F income "means, in the case of any controlled foreign corporation, the sum of [a list of types of Subpart F income]." (Emphasis supplied.) If the income is income not of a foreign corporation but, rather, income of a U.S. corporation, how can it fit within the §952 definition of Subpart F income?
However, the IRS might argue that the creation of the hypothetical corporation under Regs. §1.954-3T(b)(2)(ii)(a) is limited in scope. It exists, the IRS might argue, only to determine the Subpart F income of a CFC — i.e., to see if purchase/sales income has been split off to a low-tax jurisdiction from a high-tax remainder or manufacturing jurisdiction — and cannot apply to convert a U.S. branch into a "U.S. corporation" generally in such a way as to avoid the application of the branch rule. While the technical foundation for such an argument is tenuous, a court trying to apply a policy-based decision might possibly consider it.
Further, the IRS might argue that such a limitation to the scope of Regs. §1.954-3T(b)(2)(ii)(a) would render Regs. §1.954-3T(b)(2)(ii)(e) unnecessary. A common rule of statutory and regulatory construction, of course, is that no provision should be interpreted in such a way as to make another provision have no application. Regs. §1.954-3T(b)(2)(ii)(e) provides that income derived by a branch or CFC remainder will not be foreign base company sales income if the income would not be so considered if it were derived by an actual CFC under like circumstances. If Regs. §1.954-3T(b)(2)(ii)(a) creates a hypothetical U.S. corporation that cannot, by definition, have Subpart F income, then this provision would have no impact on such a corporation. It would, however, have an impact on branches turned into hypothetical foreigncorporations and this point could be used to rebut the argument that the IRS's potential limited interpretation of Regs. §1.954-3T(b)(2)(ii)(a) as described above is mistaken.
Moreover, Regs. §1.954-3T(b)(2)(ii)(e) itself might be applied in the case of a U.S. branch of a CFC to prevent the branch's income from creating a Subpart F inclusion for the CFC shareholder. As noted, Regs. §1.954-3T(b)(2)(ii)(e) provides that income derived by a branch or CFC remainder will not be foreign base company sales income if the income would not be so considered if it were derived by an actual CFC under like circumstances. In other words, one should assume that the branch/hypothetical CFC earns the income properly attributed or allocated to it and test whether that income is foreign base company sales income looking at the branch/hypothetical CFC's facts and circumstances and applying the various Subpart F rules to those facts. An argument can be made that, if the U.S. branch is treated as a CFC, one ought to look only to the income-earning activities of its employees that cause the branch rule to be invoked. Since those are solely in the United States, the argument goes, the income of the hypothetical CFC would be U.S.-source income effectively connected with the conduct of a U.S. trade or business.
And U.S.-source income effectively connected with the conduct of a U.S. trade or business is excluded by §952(b) from the definition of Subpart F income (so long as it is not subject to reduced tax or exemption under a treaty).
This argument, however, is subject to attack by the IRS on the grounds that the point of §952(b) is to not subject income that is already subject to U.S. tax as ECI to a second tax as a Subpart F inclusion in the hands of U.S. shareholders of the CFC. In this case, of course, there is no ECI because of the §§865 and 864 rules discussed above. As a purely technical matter, however, the regulations are relatively clear that in applying Regs. §1.954-3T(b)(2)(ii) the branch should be treated as a separate corporation selling (or purchasing) on behalf of the sourcing or distributor CFC. There is nothing to indicate that the hypothetical should consider the activities of the actual CFC where those activities are performed solely on its own behalf and not as agent for the U.S. branch/hypothetical CFC. Cf. Regs. §1.864-7(d)(1)(i). As a policy matter, however, because the income is not actuallyECI, a court might be reluctant to agree that §952(b) should be applied in this fashion.
At bottom, therefore, the IRS might argue that a CFC's U.S. branch creates a Subpart F problem for the CFC. The technical challenges for the IRS to prevail on such an argument are significant, however, so the IRS might be wise to refrain from such a challenge in the first place.
This commentary also will appear in the December 2011 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Yoder, 928 T.M., CFCs — Foreign Base Company Income (Other than FPHCI), and in Tax Practice Series, see ¶7150, U.S. Persons — Worldwide Taxation.
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